Thursday, March 7, 2013

Is it irrelevant when a central bank goes in the red?

There's been a steadyhumof articles that either worry about the Fed's potential QE-related capital losses or entirely discount them. Are central bank losses irrelevant or important? In this post I'll make the case that we should not discount losses as meaningless.

Let's say that year over year a central bank operates at a loss. It is unable to fund ongoing operations from cashflow, and to compound problems, the central bank is already operating with a bare bones staff and can't slim down.

One way to plug the funding gap is to get a capital injection. Who would do the injecting? The government, of course. This answer comes easily, since economists tend to build models that assume the consolidation of the government and its central bank. By tying them together with a nice red bow, the math and logic are made much simpler. Thus a central bank can easily run at a loss since it is really just a department within a larger consolidated entity.

Let's adopt the perspective of an investment analyst who has money on the line. Any investor knows that networks of parents and subsidiaries should never be treated as one entity. Parent companies often let subsidiaries hang out to dry, looting them of good assets and transferring bad ones in, or refusing to commit capital for the maintenance of a subsidiary's plant and equipment in order to allocate capital back to the mothership. Parents purposefully damage certain subsidiaries so as to maximize the overall welfare of the group. Those who suffer are minority shareholders and bondholders of the damaged subsidiaries... and that's why wise minority investors never make the mistake of assuming their interests are consolidated with those of the parent.

Just as parent-subsidiary relationships can be tenuous, there's no reason for investors expect the existence of a 100% guarantee of government support for its central bank. Minority investors in the Fed—anyone who holds Fed paper and deposits—must always be wary of the possibility of either being looted or being left to hung out to dry by the sovereign.

How plausible is this deconsolidated view? We in the West tend to look at everything with Fed or ECB-tinted glasses, but there are more than a hundred central banks in our world. Consider the case of the Central Bank of Philippines (CBP), for instance. According to Lamberte (2002), the CBP was harnessed by the government in the 1980s to engage in off-balance sheet lending and to assume the liabilities of various government-controlled and private companies. All of this was to the benefit of the government as it lowered the deficit and kept spending off-budget. Later on these loans proved to be worthless, leaving the central bank holding the refuse. This has shades of Enron, which used various conduits and SPVs to hide its mounting losses.

The CBP was replaced in 1993 by the newly chartered Bangko Sentral ng Pilipinas (BSP). The BSP took over the CPB's note and deposit liabilities, as well as its foreign reserves and other valuable assets (the bad assets were allocated elsewhere). The government had promised to contribute 50 billion pesos in capital to the BSP, but only paid P10 billion in 1993. The remainder owed was not forthcoming. After some seventeen years, the government finally added another P10 billion in 2011, but this still leaves P30 billion in unfunded obligations to the central bank. The BSP has been left out in the cold by its parent.

So who cares if the government refuses to inject capital into a loss-making central bank? How could that possible have any macro effect?

Well, if a central bank can't fund itself from operations, nor by financing, then it needs to sell its own assets to raise cash. So it starts selling off a few bonds here and there, using the proceeds to pay the governor's salary. Or maybe it prints off a few fresh dollars and uses those to pay staff.

As I've pointed out before, one feature of a central bank is that blowfish-like, it can suck in all of the liabilities it has issued by redeeming them for assets. This potential for redemption is one of the key forces that props up the value of central bank paper. Without it, dollars and pounds would be mere paper bits of paper. The ability to suck in and blow out liabilities is also essential to monetary policy, in particular the maintenance of price stability. Central banks use open-market purchases and sales of assets to enforce their inflation targets.

If it sells too many assets to fund itself, or prints to much cash to pay salaries, the central bank's ability to act like a blowfish and suck in its outstanding liabilities is inhibited. To compensate investors for the increased risks of non-redemption arising from central bank losses, central bank notes and deposits need to offer a higher return. This return manifests itself by a quick fall in the purchasing power of money, or inflation. From this much lower plateau, the value of central bank's liabilities will be expected to appreciate, thereby providing enough capital gains to compensate investors for increased redemption risk. But this threatens the central banks price stability targets and breeds a general lack of faith in the central bank's power. Central bank losses can have consequences.

This interesting bit from the Bangko Sentral ng Pilipinas's 2011 Annual Report captures these ideas. The bank is commenting on the losses it experienced in 2011:

Because its mandate is typically specified as the maintenance of price and financial stability, a central bank is tasked to stabilize the economy in the presence of macroeconomic shocks. Such stabilization efforts typically involve costs to the central bank... In this regard, the full capitalization of the BSP is being pursued to allow the BSP to operate fully without being constrained by balance sheet weaknesses or operating losses... The full capitalization of the BSP needs to be ensured to enhance the viability and credibility of its various policy tools. It may be noted that a central bank’s sound capitalization is critical for the effective pursuit of its mandate as well as for political economy and credibility considerations.

In sum, the threat of central bank losses isn't something that can be glossed over. There is never a 100% guarantee that a parent government will recapitalize its central bank, which means that a central bank could be forced to dilute its asset base in order to fund operations, inhibiting its ability to ensure price stability.
____________________________________

PS: Funny enough, as I was writing this, David Andolfatto posted on this topic yesterday. Here is David:

In many of our models, we assume passive support from the Treasury to support whatever needs to be done to keep inflation in check. But how realistic is this? What if that support does not materialize? And moreover, suppose that the Fed is no longer permitted to use IOR as a policy tool? What if inflation and inflation expectations start to rise? What then?

In questioning the consolidated Fed-Treasury entity, I think David and me are saying roughly the same thing.

How much is the Fed's currency monopoly worth? That's a very real asset even though it doesn't appear on a balance sheet. Although the Fed can't sell it, it can use it to recapitalize itself by withholding payments to the Treasury.

Generalizing away from the Fed, at some point a central bank's monopoly becomes a burden rather than a benefit. If year over year a central bank is required by law to pay printing costs, distribute notes + pay IOR, and its revenues aren't sufficient to cover all these costs, then the CB's monopoly is worth less than 0.

Whether the Fed can ever tumble towards such a point, I don't know. But there is some precedent for it in the world of central banking.

Yes, it's interesting to see that we were thinking exactly the same thing at the same time. I labelled your explanation above as a "monetarist" one, because it emphasizes the importance of the Fed's balance sheet in determining inflation. But as you know, the Woodford (NK) view places less (in the extreme, no) weight on the Fed's balance sheet as a factor that determines inflation. That theory just relies on the price-setting behavior of firms (Phillips curve) and the Taylor rule.

Correct me if I'm wrong, but the two views, NM and NK, are in agreement that at the zero-lower bound (ie. now, the last few years), open market purchases are irrelevant. The central bank can expand its balance sheet ad infinitum via open market operations without having any effect on asset prices. This is what Steve Williamson always argues, and what Miles Kimball calls this Wallace neutrality. It is only when we move away from the ZLB that the two views start to diverge?

I would say, yes and no. Yes, as long as we're at the zero lower bound. The difference is what happens away from the zero lower bound. If there is a "risk" of the economy moving away from the ZLB, the monetarist view takes this risk seriously, while the NK does not.

When note-issuers were originally private banks, these banks had to advertise their capitalization. Capital was the initial nugget of wealth that owners would contribute in order to underpin the bank. As long capital was large enough and the owners reputable enough, notes would be accepted, and people would be willing to sell assets to a bank.

I think central bank liabilities have value in the first place for many of the same reasons. Many of them, the BoC, the BoE, and others, were originally private to begin with.